Watchdog shake-up to avert City crisis in future

The new financial watchdog will regulate retail and investment banks, building societies and insurance companies.

FSA chief executive Hector Sants will stay on to see the body through to the end of its life before becoming the first chief executive of the new regulator, with the Bank's Andrew Bailey as his deputy.

An independent Financial Policy Committee (FPC) within the Bank, chaired by the Governor and including external members, will watch out for threats to economic and financial stability.

And a Consumer Protection and Markets Authority will regulate the conduct of all authorised financial firms providing services to consumers.

Unveiling the reforms in his maiden speech to the Mansion House last night, Mr Osborne also confirmed the Government's intention to introduce a banking levy and demand further restraint on pay and bonuses in the financial sector.

Bank of England Governor Mervyn King welcomed the changes, saying the financial crisis had proved that putting prudential regulation, consumer protection and oversight of markets together in the FSA "didn't work in practice".

And he added: "In a crisis, decisions must be made quickly and decisively and the central bank, working with government which is always responsible for any use of public money, needs to be in charge. That was one of our painful lessons."

Mr King said the Bank would focus on maintaining the stability of the banking system as a whole, looking not only at problems within individual institutions but also wider developments like the excessive lending which triggered the financial crisis.

"Just as the role of a central bank in monetary policy is to take the punch bowl away just as the party gets going, its role in financial stability should be to turn down the music when the dancing gets a little too wild," he said.

Under the new regime, the FPC will set fixed capital requirements for individual institutions, ensuring they build up "buffers" during good times which can be used to maintain credit during harder times, he said.

Mr King suggested this could have damped down over-exuberant lending in the years before the crash, saying: "The Bank's sermons on the storms ahead would have had more influence if, at the same time, a collection plate was passed round the congregation so that money was available in the event that the church roof had to be replaced."

But he said regulation alone would not overcome the "avarice" unleashed by banking structures which created incentives to take excessive risks.

"Incentives must be right," he said. "One misalignment of incentives today is the implicit guarantee to banks that are 'too important to fail', so that creditors have little incentive to monitor the behaviour of banks because they believe they will be bailed out.

"This problem is too important to ignore. There is no one simple solution. But we should not shy away from radical reform just because of the opposition of vested interests."

Mr King also welcomed the new Government's determination to rein in Britain's national debt with spending cuts and tax rises over the next five years.

His comments stand in stark contrast to the rift between the Governor and then Chancellor Alistair Darling at last year's annual gathering of City bankers, when Mr King left no doubt about his belief that Government fiscal policy was wrong.